Investors have begun pulling their money out of conventional investment tools, such as stocks, equity funds, bond funds, and money market funds and look toward alternative investment tools in hopes of attaining a positive return on their investment. One such alternative investment tool is a hedge fund. A hedge fund uses a pool of capital for leveraging an investment portfolio that uses a private partnership as its structural format. The private partnership consists of a General Partner, who is typically the investment manager of the fund, and Limited Partners, who are the individual investors. The General Partner receives a fee for managing the investments, but only if the fund is productive. Therefore, by heavily weighting the investment manager's fee based on performance incentives, hedge funds typically attract the brightest individuals in the investment business and thus are attractive to investors.
Historically, the primary goal of hedge funds has been to reduce volatility and risks while preserving capital and providing positive returns under all market conditions. Typically, hedge funds utilize a variety of financial strategies to minimize the risks to investors, enhance returns, and minimize the correlation between the equity and bond markets. For example, hedge funds may employ short selling or arbitrage, engage in trading derivatives, investing in the anticipation of specific events, such as mergers or acquisitions, and investing in deeply discounted securities. This versatility allows hedge funds to generate positive returns on investment regardless of whether equity and bond markets are rising or falling.
Hedge funds provide several advantages over standard mutual fund investments. First, as mentioned above, hedge funds are established to deliver absolute returns. That is, the primary goal of hedge funds is to return a profit under all circumstances—even in a Bear market. The success of mutual funds, on the other hand, is compared to a relative index, such as the Dow Jones Industrial Averages, Standard and Poor's 500, or other index. Thus, a mutual fund may have a negative return but still be considered successful if it outperforms the indices.
Another advantage is that hedge funds are particularly suited to protect investors against declining markets. Because hedge fund managers have a wide variety of hedging strategies available to them, hedge fund managers are able to generate absolute positive returns in declining markets. Mutual funds, on the other hand, are limited to converting a portion of their portfolios to cash or to shorting a limited portion of stock index futures to protect portfolios against declining markets.
Yet another advantage of hedge funds over mutual funds is that hedge funds are unregulated and, therefore, unrestricted in their investment options. Thus, managers of hedge funds are free to employ a variety of strategies to increase profits or reduce volatility. Mutual funds, on the other hand, are highly regulated and are restricted to the use of non-conventional investments, such as short selling and trading in derivatives, which make it more difficult for fund managers to outperform the market. However, conventional hedge funds have one restriction, which is imposed by professional investors. Professional investors expect and typically require that the hedge fund manager limit his or her investments within an area of specialization and competence. Thus, hedge funds tend to operate within a given specialization, which requires a particular expertise by the manager.
Although hedge funds provide a powerful alternative to and provide advantages over conventional mutual funds for investors, hedge funds have several drawbacks. First, unlike mutual funds, hedge funds are not available to the general public. Rather, hedge funds are available only to Accredited Investors and Qualified Purchasers. Accredited Investors are individuals whose net worth exceeds one million dollars, or individuals whose individual income exceeded two hundred thousand dollars, or whose joint income with a spouse exceeded three hundred thousand dollars in each of the two preceding years. Qualified Purchasers, also known as “super” Accredited Investors, are individuals, whose investments total more than five million dollars, either individually or jointly, family businesses that have more than five million dollars in investments, business that have discretion over twenty-five million dollars in investments, and trust sponsored Qualified Investors. Furthermore, only one hundred Accredited Investors, or an unlimited number of Qualified Purchasers, may invest in any single hedge fund. However, typical hedge funds have fewer than one hundred investors. Therefore, the pool of potential investors for hedge funds is limited.
One potential limitation of hedge funds is that they are not always diversified. Hedge funds are sometimes limited to a single sector, niche, or industry. Although hedge funds are designed to provide an absolute return, the non-diversification can lead to high risks and high volatility. For example, if particular hedge fund investments are limited to the technical sector (e.g., computing stocks, telecommunications stocks, etc.) the return on investments may vary widely with changes in the technical sector of the stock market. Although hedge funds are designed to minimize the volatility and risks, investing in a single sector can lead to inherent fluctuations in the rate of return, which may be more than some investors are willing to tolerate. Furthermore, investment strategies differ between different managers. Each hedge fund manager will apply different amounts of hedging and different amounts of leverage to his or her portfolio, thereby leading to different amounts of risk. The different management styles in coordination with the single sector investing of hedge funds may increase the volatility beyond the point many potential investors are willing to accept.
One method to minimize the volatility of investing in a single hedge fund was the creation of a “fund” of hedge funds, or a “fund of funds” as it is commonly known. A fund of funds mixes and matches the most successful hedge funds and pooled investment vehicles into a single fund, thereby spreading the investments among several different types of hedge funds and investment vehicles. A fund of funds mixes a variety of hedge funds and management styles to meet an investor's specific goals and risk/reward objectives while diversifying his or her portfolio. By diversifying the fund's classes and the management strategies of the fund managers, a more consistent return may be achieved. Also, the volatility of the funds can be controlled depending on the mix and ratio of investment strategies integrated into the fund. Thus, by creating a fund of funds, the goals and risk/reward objectives can be tailored to the needs of individual investors. However, the fund of funds approach has several drawbacks. First, conventional fund of funds still require that any investor must meet the requirements for an individual hedge fund. For example, fund of funds are only available to Accredited Investors and Qualified Purchasers. Furthermore, the minimum investment amounts associated with individual hedge funds also applies to the fund of funds. Moreover, the fund of funds is still a Limited Liability Partnership. Therefore, the individual investors, or limited partners, retain a substantial amount of risk.
Therefore, there is a continuing need for a method for allowing investors to participate in a single or portfolio of hedge funds managed by one or more emerging managers, or one of countless other investment vehicles, including, but not limited to REITs, indexed shares or the equivalent of Exchange Traded Funds (ETFs) related to any asset class, mutual funds, currency funds, and the like, with the security and liquidity provided by a guaranteed United States dollar or foreign-backed securities with a guarantee that is equivalent to the guarantee backed by the U.S. Government.